Stock Exchange 2.0 – What’s Next?

In this guest post, Gibraltar Blockchain Exchange CEO Nick Cowan examines how blockchain technology has the potential to revolutionize the stock exchange.

Stock exchanges as we know them could be turned on their head thanks to the innovative potential of blockchain technology.

Certain characteristics of traditional stock exchanges, such as intermediaries and contract loopholes, have congested the trading process and prevented instant transactions from becoming the norm.

Blockchain technology uses a decentralised and automated system, meaning it has the potential to remove these barriers to instant trading and revolutionise how stock exchanges function. The ability of innovators in the blockchain space to create practical alternatives to the current trading system will therefore go some way to defining if blockchain can force its way into the mainstream of financial services.

The Evolution of Stock Exchanges

The dominant stock exchanges like London and New York developed in the 19th and 20th centuries from relatively small collections of traders into huge exchanges that have enormous impact on global finance. The emergence of the NASDAQ (exchange) in 1971, with its focus on electronic trading and attracting high-tech firms, has probably been the last big disrupter to the market in recent times.

Tight regulations and processes have developed in tandem with the growth of these large exchanges in order to create a fair and regulated trading environment.

But the onerous list of tasks that underpin those rules have allowed the current system to become inefficient and time consuming. Transactions can take more than 3 days as they move through the process of pre-trade, trade, post-trade and custody stages due to the involvement of a number of intermediaries.

The need for so many layers of third party involvement in trading transactions is required to guarantee the trust of all stakeholders involved. Blockchain technology, by its nature, is a solution to the problem of how you complete a transaction between two parties without endless broker and auditor interference, as everything would be built around a smart contract. Smart contracts use crypto code to enforce the terms of an agreement - they are self-executing and are best suited to industries with well-established regulations and quantifiable contract agreements. Once a transaction enters the blockchain it cannot be altered retrospectively, meaning it is completed in a more efficient manner without security being compromised.

While widespread use of blockchain technology across a variety of industries is currently still rare, there have been a number of impressive innovations in financial services that indicate that a sustainable application of the technology is just around the corner. Nasdaq Linq, for example, is a digital ledger technology in the USA using blockchain for issuance, cataloging and recording share transfers on the Nasdaq Private Market. It was the debut platform launched as part of Nasdaq's blockchain technology initiative and provides Nasdaq clients with a historical record of any transactions they complete and allows for increased auditability.

JP Morgan trialed the technology as early as 2016 when they partnered with blockchain startup Digital Asset Holdings to reduce the complexities and costs involved in selling loans. Late last year, the Australian Stock Exchange (ASX) announced their intention to replace their existing CHESS system for settling trades with Distributed Ledger Technology supplied by Digital Asset Holdings. The new system is expected to be up and running by September 2020 and, if successful, will go some way to proving the worth of an adaptive business strategy for other exchanges, while also putting Australia on the map for blockchain innovation worldwide.

Challenges For Blockchain Adoption

Such forward thinking by traditional financial institutions should no doubt be welcomed by blockchain startups and is precisely the type of momentum needed to move the technology forward. Nevertheless, the pathway to marrying the requirements of complex financial transactions and data with a technology still in its infancy is by no means straightforward and this certainly applies to stock exchanges looking to adopt blockchain. External factors will certainly play a part as regulators in the heavyweight economies of the US, UK and China ramp up efforts to introduce a clear regulatory framework in their respective regions. Smaller jurisdictions like Gibraltar and Liechtenstein have adopted a more open minded approach to cryptocurrency regulation in a move to differentiate their offering as a destination for fintech companies. The combination of fair, supportive crypto regulation with a conducive business environment has allowed these smaller countries to punch above their weight and attract the attention of local stock exchanges and blockchain startups alike.

Regulations aside, the fundamental challenge for innovators wishing to successfully adopt blockchain into the stock exchanges of the future will lie in the fine detail of scalability and process management.

Creating a blockchain infrastructure which can process the volume of transactions required by a large stock exchange will need to involve a mechanism for differentiating between small and large size transactions, similar to the Lighting Network system used for bitcoin currency. Furthermore, stock market investing has developed its own sophisticated ecosystem to meet the needs of different types of investors (retail investors, hedge funds, mutual funds etc.), who in turn look to specialised brokerage firms. Blockchain solutions will need to provide a similar level of expertise in order to meet investor expectations before large scale implementation occurs.

The evidence is clear though.

The opportunity to reduce costs, improve efficiency and ultimately improve investor satisfaction with their service by implementing blockchain solutions will prove too strong for traditional, centralised exchanges to ignore in the long term. The first steps for stock exchanges will involve embracing both the forward thinking required to make implementation a reality and a willingness to transform the ecosystem of stock exchanges as they stand. Externally, exchanges should welcome sensible regulations and introduce robust due diligence and admissions processes for token trading, which will ultimately act as the foundation for sustainable growth to all market participants.